While we are left guessing as to what the positions are, we have even less clue of how JPM decided to put on the positions. In the end, that is a key question.
Chest Pounding Gorillas
Maybe the trader at JPM had been selling some IG9 tranches for something to do. They liked the risk and thought it had some value. After a couple of sales, he asked the dealer buying the protection who the other side was. Hearing the name of the other side of the trade just makes them laugh. They can’t stand that “little jerk”. Then and there the trader decides to “push this down the other guys throat”. Plain and simple he is going to rub this trade in their mush, and watch them scream in pain. So he keeps selling. The other side, equal loathing of the JPM trader, and at this stage, with “intrinsic value” on his side decides to circle the wagons and fight this “arrogant bastard”. One keeps selling. One keeps buying. All through an intermediary happy to encourage the rivalry, thinking that the P&L on trading the unwind will be even bigger than the P&L of putting them into these positions. And there you have it, two 800 pound gorillas on either end of the trade, both pounding their chest trying to prove which one is the mightiest of all.
I don’t think you can totally discount that as a possibility, but frankly it’s unlikely.
The Thoughtful Gorilla
So in the fall of 2011, after the markets rally from their late September lows, a senior level meeting is called. The bank had performed well during the crisis, which at least for now seems to have abated, but management wants to know what to do.
The question for this group of senior management is what can they do in order to be a in a better position for the next wave.
Talk is initially about Europe. In the end, they all agree their exposure is small, and that there is little they can do if the market perceives their exposure wrong. They decide to remain small in Europe, do a better job of getting that message out to the investment world, but really don’t think there is much more to do there.
Mortgage lawsuits is the next big subject of conversation. They once again all agree that while the risk is big, they are reserving against it, and fighting it the best way they can. So far, they all agree, politicians are making the right noises about wanting to get this resolved so that they can move on. They talk about shorting BAC or someone else who has big exposure, and maybe even decide to do a couple of trades, but since at this point the risk is primarily legal, and they believe they are pretty well reserved, they decide to move on, but do set up a task force to look into ways to benefit if the negotiations with the attorney generals starts to get worse.
So what is the biggest risk? High yield is next up for discussion. What’s our exposure here, asks the big man, knowing full well the bank has cut back its bond inventory. Well, we have a lot of leveraged loans out there. We have been lending and its been successful. Not only are we making some money, but we are starting to dominate the new issue process. We are the #1 issuer of junk bonds in Europe and the North America. The loans are secured and floating rate, so have been doing well, but they were hit in the last sell-off, and had the bond market continued to sell off, they would have taken a bigger loss.
But that’s not all. The real problem is that in a down market, we see issuance dry up. So we give up those profits, but a lot of our secondary trading profits come from the fact that we control the allocation process on new issues. New issues have become the primary source of “alpha” generation for most credit hedge funds. They need those allocations and the pop on the break to make money. They drive secondary flows our way to get better allocations. So the new issue market dries up, and we don’t get the fees, our secondary trading volumes dry up, and we have this massive expense base of investment bankers that we need to keep around for when it picks up again.
The big man thinks that all makes sense and asks the obvious question. What is the real downside to the bond market and how much do we need to make if that happens. Let’s say HY bonds down 10 to 15%. They were down about 10% from high to low in 2011 and no reason this couldn’t happen again going forward. Down 5% isn’t a big deal, and 10% the market was dysfunctional, and down 15% it will lock up and definitely drive loans down and put new business on hold.
Okay, so in a down 10-15% scenario, how much money do we need to make? $5 billion. Looking at our loan book, and business risk, let’s assume we need to make $5 billion in a down 12% market. That should keep us profitable and let us take advantage of the chaos. Man, that was one thing we missed, we were in better shape than most last quarter, but weren’t ready to step up and take real advantage of the situation. With that sort of hedge, we could crush the competition and come out of this even further on top.
Okay, so how do we hedge this? Let’s look at HY17. We need to short $42 billion if we want to make $5 billion on a down 12% move. Wow, that’s a big number. Okay, any other suggestions? After a brief discussion about using equity puts or other alternatives, they decide the correlation might break down too easily, and paying up for vol could be a disaster, so they settle on a HY short.
What $42 billion of HY short going to cost? About $2.5 to $3 billion per annum. What??? You got to be kidding me? Nah, market is between 6% and 7%, its going to cost a lot. We have the loans and the other revenues to cover it.
No, we can’t do that. It would be too big of a drag on revenues. The hedge would cost more than the business makes. Besides, this is just for disaster protection. What can we do to offset this?
Well we could sell some IG. It would give us income to cover the short. Also, if the market continues to rip higher, we should make up a lot of the mark to market losses we would get on our HY short. On the downside, we would give up some of the gains, because IG will outperform.
Okay, let’s say we sell $100 billion of IG, what does that do? IG is about 1.25% per annum right now, we’d pick up 1.25 billion or so of carry against the HY short. Okay, that’s a bit more reasonable. What about the other scenarios. If HY rallies 5% more from here (which is about the max we think can happen). We think IG would do better by 1 to 2%. So we would lose about $2 billion on the HY short, but make between $1 and $2 billion on the IG long. And in the downside, if HY goes down 12%, we think, given the improved IG balance sheets and fact that IG has few financials, the IG index would only go down 2% to 3%, so about $2.5 billion. Ugh, but then we would only make $2.5 billion in the downside and not the $5 billion.
What can we do? I know we can get bigger, but these numbers are already getting huge.
Tranches? Who said tranches? So you think we could buy the “first loss” tranche of some HY tranches and sell some “mezz” tranches of IG? Interesting, explain some more.
So on HY tranches, we go short some tranches that benefit from immediate defaults. We go shorter than 5 year, because I think the market is under pricing near term default risk. I can get names like AMR in there dirt cheap and they could default by the end of the year. Plus, if this is more disaster scenario, the curve makes huge sense. For a 5% move, the front end won’t move much, but if we are down over 10% in the market, there will be no bid for short dated bonds. Curves will go inverted and this short dated first loss protection will do incredibly well.
On the other side, the IG9 tranches trade cheap as hell. No one really wants to own them, but we can sell second loss protection and get big premiums. The IG9 tranches pay the same running spread as the HY tranches – 5% per annum. So doing even notional we can control the running cost.
We will have to pay a decent amount up front as the HY tranches cost more than the IG tranches, but at least they are carry neutral.
I really like the trade. If the world turns to crap again, they HY market is going to get crushed relative to IG but since this trade is even more focused on defaults as they affect subordination and actual losses, it really shines. By the time we are getting 3-4 defaults in investment grade, we would just be eating into the tranches we sold, but by then HY is probably having 10-20 defaults, and we will have fully monetized our shorts. I think we can do this where we make at least $5 billion in the downside, and may even make a bit if the market rallies.
I like this. It seems far more controlled than just doing the index. I like how it performs in a big move down, because yes, the investment grade companies won’t default. Everything about the system is now geared to making sure we support IG companies, but the HY ones, no one at the Fed is going to be breathing down our neck to support them. This is good, and it will be a star in the new Fed stress tests.
Let’s go with it….
Thoughtful Plan with Bad Execution
I have no clue if anything like the above conversation took place, but I would bet on something like that occurring as being the genesis of the trade, rather than the chest pounding first version.
There are things I don’t like about the execution. The size was just too big for the market to absorb, so in the end everyone knows what trade they had on. That hurt execution. They continued to put the trade on once they had driven indices through intrinsic value. While they were largely doing tranches, they were also doing indices. They were doing this across the globe.
The problem with continuing to add risk after having driven the prices to extreme levels of richness and cheapness means you aren’t getting good value. At that point a change in strategy was warranted. Maybe there were more discussions and they decided that the F9 monkeys were mispricing the tranches, so it was okay to continue. It is at this stage, I think they may have pushed too far.
It certainly hurt them that the other side would become emboldened once “fair value” was on their side. Lots of questions of what the trade is? When they put it on? Why they kept growing it? How much money has already been booked for this trade? How much money has been made on assets in non AFS accounts?
I think mistakes have been made. This trade will ripple through the entire system as it was large, but the CIO office faced many counterparties, who in turn faced many counterparties, who all tend to transform the trade in various ways. Some have tranches outright. Some have “correlation” books running the tranches versus index and single names. Some have the index outright. Some have index vs index, and others have index vs single names. It will take time for this to play out, but I think we will see the highest beta hy names perform well, as much of the short dated bid for protection came from these trades, and low beta IG to be soft, and the IG9 specific names (like MBI) to feel pressure until the technical is cleared up.
That is the final question, how much does JPM have left, and how much of a rush are they in to cover it?